The Physics of Wall Street: a brief History of Predicting the Unpredictable

Epilogue: Send Physics, Math, and Money! 
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is an important, ongoing policy concern. But it’s no different in kind 
from other regulatory problems.
there is still a worry, however, even after you agree that derivatives and 
their associated models are tools, to be used judiciously or otherwise. 
Surely there are some tools — the hydrogen bomb, say, if one can think 
of that as a tool — that are so dangerous that the world would be a bet-
ter place if they didn’t exist. Perhaps derivatives are, in Buffett’s words, 
“financial weapons of mass destruction” — tools that can be used or 
misused in such destructive ways that no amount of economic growth 
is enough to counterbalance the risks. one might even think that the 
2008 crisis is evidence of the enormity of the dangers of mathematical 
modeling in finance. I don’t think this is right. to see why, it’s worth a 
careful look at what happened in 2007–2008.
In the film It’s a Wonderful Life, the main character, George Bailey, 
runs a savings and loan bank. It’s a fairly standard kind of bank: cus-
tomers deposit their money into an account, in exchange for safety 
and interest; the bank then turns around and lends the money out, 
usually as mortgages or business loans. this system works well as long 
as depositors are by and large happy to leave their money in the bank. 
on George Bailey’s wedding day, however, as he and his new wife drive 
past his bank, they see a crowd of people clamoring to get in. A rumor 
has spread that the bank is in trouble and the people of Bedford falls 
(Bailey’s town) want to withdraw their deposits.
Bailey jumps out of the car, realizing there’s been a run on his bank. 
Inside, he explains to the crowd that their money isn’t in the build-
ing — it’s in their neighbors’ houses and their community’s stores and 
businesses. the system fails if everyone tries to withdraw at once, since 
the bank doesn’t keep enough capital on hand to reimburse all of the 
depositors. In a moment of tragic (but characteristic) selflessness, Bai-
ley realizes that he has a pile of cash on hand — his honeymoon money
— and offers to pay some of the depositors out of that, so long as they 
don’t ask too much. He has just enough money that, at the close of the 
business day, the bank has $1 left and they can shut the doors for the 
night without going out of business. they have survived the run, but 
at the expense of Bailey’s dreams of traveling the world.

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t h e p h y s i c s o f wa l l s t r e e t
Bank runs were fairly common during the depression, and even 
more common during the nineteenth century. they were associated 
with financial panics, periods in which the economy seemed especially 
uncertain and no one was sure which banks would survive. A small 
piece of news that a particular bank was endangered could practically 
ensure that the bank would fail. today, bank runs in the United States 
are a thing of the past, because in 1934 the U.S. government instituted 
the federal deposit Insurance corporation (fdIc), which insures all 
consumer bank deposits. now there’s no reason to make a run on a 
bank, even if you think it’s failing: your money is insured by the federal 
government, no matter what happens.
In the Introduction, I described the quant crisis — the week in Au-
gust 2007 when all of the major quant funds fell to pieces, for no ap-
parent reason. this was the first hint of a coming catastrophe in the 
world’s financial markets. But what caused the quant crisis? In effect, 
the quant funds were an early casualty of a much larger-scale bank 
panic that was setting in that summer, and that would last for more 
than fifteen months. this panic didn’t concern consumer banking, 
which is protected by the fdIc. Instead, it was a panic that affected a 
shadow banking system that has developed in the United States over 
the past three decades. the shadow banking system works like nor-
mal banking in principle, but on much larger scales — and with no 
oversight or regulation. It consists of lending between banks and large 
corporations (including other banks).
When a firm has cash reserves — say, a few hundred million dollars
— it needs a place to deposit them, just as anyone else needs a place 
to deposit cash. otherwise, the cash doesn’t bear any interest, which 
amounts to a loss of value. So what firms do is deposit their cash re-
serves with other firms. this is basically a short-term loan from one 
bank or firm to another. In exchange, the depositor demands some 
sort of collateral. one standard choice for collateral would be govern-
ment bonds, which are essentially risk-free and pay a small amount of 
interest. But there are only so many government bonds in the world, 
and many people (and other governments) buy them as long-term in-
vestments. And so, as firms’ demand for places to deposit their cash 

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